Head of FX Strategy
Summary: FX volatility is picking up as US yields have posted a strong move higher over the past week and volatility in risky assets has spiked, particularly yesterday, but the rise is so far rather muted outside of a significant jolt to sterling yesterday. That could change if the US dollar finally takes out key resistance, although it still feels like FX is a follower here, not a leader.
FX Trading focus: Volatility picking up, but still quite sluggish. Sterling stumbling.
Implied volatilities among currency pairs are a slightly mixed bag here over the last couple of weeks of heightened volatility in risky assets – EURUSD 1-month volatility actually bottomed last Friday below 4.6% and ahead of the weekend election, which gives a sense of how little the market was anticipating that particular event. With EURUSD poking at the bottom of the range, it has picked back up above 4.9%, but that is a historically very low level. Elsewhere, volatility has picked up more, with USDJPY 1-month hitting its high level since July just below 6% before easing back lower (that volatility measure was as low as sub-5% less than a week ago). Sterling volatility has picked up more sharply. As I mention in the EURUSD chart below, the setup that could really jolt volatility might be a further risk deleveraging in which bond yields actually stay sidelined or even fall rather than rise, which might turn the tables again on JPY traders. Until then, the FX market feels quite sluggish outside of the sterling and JPY moves of late.
Yesterday, sterling hit a brick wall and fell sharply versus both the US dollar and the euro, taking out key support for the currency. I suspect the chief driver is sterling’s general sensitive to risk sentiment, its vulnerability in terms of the ongoing energy crunch and prices of commodity imports, and a UK economy beset with capacity constraints, while the furlough scheme is set to lift, which could mean a slowing of the recovery. In the pipeline, we have a government that looks determined to ensure that it shores up the budget imbalance, i.e., austerity incoming. GBPUSD fell through the key 1.3600 area and is already having a look at the huge 1.3500 level that was important in both 2019 and 2020. EURGBP, for its part, reversed the modest kneejerk reaction to the downside in the wake of the German election and ripped above the range of the last several weeks and well clear of the 0.8600 level. The pair is trading near the 200-day moving average (from below) for the first time since early January.
Chart: EURUSD – what’s with the slow-mo act?
I suspect there are a couple of drivers of muted EURUSD volatility over the last few sessions, relative to what we have seen elsewhere. First, the market quickly unwound the slightly negative reaction to the euro in the wake of the German election, at least in EURGBP, where the Monday sell-off was swamped with a massive rise yesterday that cleared several weeks of range-trading. Second, the focus on rising yields has meant more focus on selling JPY rather than the euro, where yields are seen as capable of responding in sympathy, if with lower beta, to the rise in US treasury yields, while the Japanese policy of yield control keeps the JPY the weakest whenever yields rise. So that begs the question of what could cause a EURUSD sell-off to extend notably below the 1.1664 support. It appears that this would require a chunky further risk deleveraging without the proximate cause being a . That would allow both EURUSD and EURJPY to come under pressure and set up the run at the structural support in EURUSD, which starts with the 1.1500 area and extends to the arguably existential level of support at 1.1290, the 61.8% retracement of the entire rally from post-pandemic outbreak lows to the highs in January. A strong turn in the mood/reversal needed to neutralize the downside threat.
In Japan, LDP chooses the “safe” candidate: The race for the LDP leadership is over, with the favourite among party leaders, Fumio Kishida, prevailing in a run-off versus the more outspoken, and far more popular Taro Kono, who would have been more interesting as someone who has spoken out against Abenomics and BoJ policy. This sidelines the potential for more policy dynamism for now in Japan as Kishida is seen as the “continuity” candidate. The JPY has firmed smartly today more as a function of consolidating bond yields rather than the implications of this vote, as we await further political signals up to the snap election set to take place within two months.
US Senate to try advancing stop-gap funding measure to avoid government shutdown: US Senate set to vote today on stop-gap bill for temporary debt ceiling suspension until Dec. 3 - this time, the bill will not be attached to an increase in the debt ceiling, but would still leave unanswered whether Congress can manage to eventually raise the debt ceiling and pass the two outstanding spending bills – the smaller infrastructure packaged passed by the Senate but not by the House and the larger $3.5 trillion social- and climate package.
China keeping CNH very firm: given the policy uncertainties in China that are leading to fears of weaker growth ahead and reduction of international allocations to Chinese equities, one would think that the CNH should trade weaker than it has, particularly as the US dollar has been very firm and the CNH has historically been allowed to weaken, if with lower beta relative to other currencies, versus the USD when the latter is strengthening. Perhaps China is holding up the currency out of a general desire for stability amidst the significant market turmoil of late and at the margin, to avoid even worse inflationary impact from high import prices for commodities as it tries to shore up energy stocks ahead of the winter heating season. For whatever reason, the lack of USDCNH is likely contributing a significant damper to overall FX volatility. USDCNH 3-month implied volatility is trading just above 4% and thus in the lower part of the of the multi-year range.
Table: FX Board of G10 and CNH trend evolution and strength
What stands out above all else recently is the CNH’s slavish tracking of the US dollar, given the latter’s notable strength of late, as noted above. The chief development of note elsewhere is the acceleration, if still modest, in the US dollar higher and the pronounced sterling weakness. Commodity currencies are sideways on the tension between the negative drag from risk sentiment while rising prices are a positive.
Table: FX Board Trend Scoreboard for individual pairs
Note the still low volatility levels for most currency pairs (the shading of the ATR indicates low volatility if light blue or especially darker blue). Also note USDCAD possibly flipping back higher here, while GBP weakness is so pronounced that it has even flipped negative versus the also weak JPY.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
